Monetary Policy and Global Bank Lending: A Reversal Interest Rate Approach

Abstract

This paper studies the impact of monetary policy on the credit allocation of globally operating banks. First, we document that, at the country level, banks’ bias toward domestic lending fell in the early 2000s but increased by 10% during the low interest rate period after the Global Financial Crisis. To account for this finding, we develop an analytical framework for global banking based on a portfolio approach. In the model, global bank allocates their lending to both domestic and foreign borrowers for diversification benefits, but foreign lending comprises higher uncertainty due to cross-border frictions. Managing the uncertainty is costly and depends on banks’ profitability driven by margins between lending and deposit rates. As a result, the effect of expansionary monetary policy on bank lending allocation is state-dependent. In times of low interest rates and large balance sheet, a further cut in the interest rate decreases bank profitability and has opposite effects on domestic and foreign lending, thereby increasing home bias. Extending the model to a dynamic general equilibrium setup with nominal rigidities, we find that with the portfolio re-balancing of the global banks, the prolonged period of low interest rates is accompanied by a persistently high home bias, as shown in the data, and the overall effectiveness of monetary policy is compromised.

JEL Classification: E43, F34, E58, F41